Opinion: Four reasons for investors to buy biotechnology stocks now

Beaten-down biotechnology stocks have been so cheap for so long, rattled investors pray every day that a big drug company with firepower will swoop in and buy one to spark interest in the industry.

They got their wish Monday when Pfizer
PFE, -0.25%
said it agreed to acquire Anacor Pharmaceuticals
US:ANAC
for $5.2 billion. Elsewhere, a battle over cancer-drug company Medivation
US:MDVN
is heating up. Sanofi
SNY, -0.51%
is turning the screws to get the company to agree to a takeover, and other bidders are circling.

Those takeover efforts are a good signal that biotech stocks are just too cheap — in case you hadn’t noticed. This is just one of several reasons the group may soon take a sustained turn for the better, say biotech experts.

Let’s take a look at four reasons why biotech stocks are attractive now.

There will be more takeovers

Pfizer is snapping up Anacor for around $100 a share, a 55% premium. Anacor is a so-called five-bagger since March 2014 when I suggested it at about $20 in my stock letter, Brush Up on Stocks. (I reiterated the company in a pullback to around $60 a few weeks before the buyout.)

These kind of rich profits and takeover premiums are good news for biotech investors, because they put fear in the hearts of anyone short-selling the group, or betting on a decline. That tones down some of the negativity.

“For investors who are short, Anacor getting bought makes them a little scared. Any time companies get bought, it reminds you that takeouts do happen,” says Mike Tung, a medical doctor and biotech sector investor at Turner Medical Sciences Long/Short Fund
US:TMSEX
which has a solid medium-term record. It beats competitors by 8 percentage points annualized over the past three years, according to Morningstar.

Anacor-style premiums also boost confidence in the sector.

“It reminds people that we have real upside in the space, and not just downside,” says John McCamant of the Medical Technology Stock Letter. “It basically balances out the declines caused by Phase III blowups.”

Biotech money managers predict more buyouts ahead.

“A lot of assets have gotten very cheap. This could kick-start mergers and acquisitions,” says Mindy Perry, a health-care sector portfolio manager for Manulife Asset Management. More takeovers could be a huge driver for the group, she says.

Potential buyers? Any of the big U.S., European or Japanese pharma companies that have let their research efforts lapse over the past few decades. And that includes most of them.

“The reality is, large pharma doesn’t do a lot of innovation. They do partnerships,” says Tung.

“Large pharma and biotech companies need to start showing revenue growth, and the only way to do that is to buy a company that has a drug or will soon,” says Brad Loncar, of Loncar Investments, who developed the Loncar Cancer Immunotherapy
CNCR, -0.08%
ETF.

He says Gilead is a perfect example.

“The last earnings report was really just terrible,” says Loncar. “If you were not skeptical on Gilead before, you are now. They are the poster child for what we are talking about. They need to do a transformational deal.”

He also highlights Sanofi, because it faces competitive pressure in diabetes treatments, and AstraZeneca
AZN, -0.10%
since it has to live up to sales growth guidance.

“You have companies where investors are expecting a certain amount of revenue by a certain date, and mergers and acquisitions are the only way to get there,” Loncar says. Pfizer is in the same boat, especially since the government just blocked its attempt to boost earnings by relocating its headquarters abroad to save on U.S. taxes.

All of these potential bidders certainly have the piles of cash — and strong cash flow — to go shopping. Pfizer has around $19 billion in cash. Gilead Sciences has over $8 billion. Johnson & Johnson
JNJ, -0.55%
has a massive $40 billion. Allergan
AGN, +0.10%
will have a war chest of over $34 billion after it sells its generics business to Teva Pharmaceutical Industries
TEVA, +0.77%

So who else might get taken over? The key here is to look for biotech companies that have approved products, with more on the way, or products that have all but gotten approval. Going for “de-risked” assets like these takes a lot of the uncertainty out of the equation for the big pharma buyers, says McCamant, of the Medical Technology Stock Letter. That’s why they’ll be the targets. And the less likely targets? The earlier-stage research companies, derisively known as “science projects.”

One potential buyout candidate near the top of McCamant’s list is Acadia
ACAD, +0.28%
Acadia develops drugs for mental illnesses associated with diseases like Parkinson’s and Alzheimer’s. It recently got its first product approved to treat psychosis associated with Parkinson’s. The drug launches in June. Acadia is now working to demonstrate its drug will treat psychosis associated with Alzheimer’s. McCamant cites Incyte
INCY, +2.44%
and BioMarin
BMRN, +0.41%
as potential targets, too.

Valuations appear cheap

Even if more takeovers fail to materialize, biotech stocks look attractive because they are so cheap. Perry, at Manulife Asset Management, favors large-cap biotech stocks. She describes them as “very undervalued.”

Take Biogen, for example. By her analysis, the current stock valuation merely incorporates the future profits from all the drugs the company already has on the market.

“You pretty much get the pipeline for free,” she says. And that’s a bargain because it’s a decent pipeline. It includes two drugs with solid potential — for multiple sclerosis and Alzheimer’s disease.

While stocks overall have recovered most of their losses suffered during the start of the year, the iShares Nasdaq Biotechnology ETF
IBB, +0.56%
is still near 52-week lows. “All of the big biotech companies have become value plays,” maintains McCamant.

Research breakthroughs and drug approvals

“One thing that has gotten lost in the malaise of the last six months is how much innovation is going on,” says Loncar.

He cites ongoing breakthroughs in areas like cancer immunotherapy, gene therapy and CRISPR gene editing, among others. “There is a lot of really interesting stuff going on. And that is how this sector creates value. None of that has really changed.”

Possible milestones on the horizon? Perry expects news on Biogen’s anti-LINGO-1 therapy for multiple sclerosis in June or July. She expects news on Eli Lilly’s
LLY, +0.56%
Alzheimer’s drug, solanezumab, around the end of year. Market-moving news will also flow at important health-care conferences around the corner like the American Society of Clinical Oncology (ASCO) meeting in early June.

We’ll also continue to get market-moving product approvals by the Food and Drug Administration (FDA). Investors were reminded of this potential May 18 when biotech stocks got a strong bid after Bristol-Myers Squibb
BMY, +0.91%
announced the FDA approved its Opdivo treatment for Hodgkin’s lymphoma.

Hillary is going to lighten up

Once Hillary Clinton closes the deal on the Democratic nomination, she’ll move to the right in her campaign against Donald Trump, since she’ll no longer be pulled to the left by Bernie Sanders. This will be bullish for biotech because it will mean drug pricing will be less of a presidential campaign issue.

It might also help with drug launches. Many of them have been tepid because pharmacy-benefits managers, emboldened by political rhetoric on high drug prices, have been aggressively pushing back on costly drugs, says Loncar, of Loncar Investments. He thinks this could change if drug pricing becomes a lower priority in the presidential campaign.

Keep in mind that if you buy biotech stocks, they are notoriously volatile. So they require calm nerves, and a long time horizon of a few years or more.

Near term, overall market strength will help a lot. If I’m right in my market forecast, sentiment has turned so negative, that’s exactly what we will get. You can read more about my outlook here.

At the time of publication, Michael Brush owned shares of ACAD, INCY and BMRN. Brush has suggested ANAC, ACAD, INCY, BMRN, GILD and BIIB in his stock newsletter, Brush Up on Stocks. Brush is a Manhattan-based financial writer who has covered business for the New York Times and The Economist group, and he attended Columbia Business School in the Knight-Bagehot program.

Michael
Brush

Michael Brush is a Manhattan-based financial writer who publishes the stock newsletter Brush Up on Stocks. Brush has covered business for the New York Times and The Economist group. He attended Columbia Business School in the Knight-Bagehot program.

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